Navigating Emerging Markets Concentration: Risk Management and Best Practices

Emerging market investing is evolving as equity structures shift and market concentration reshapes the global economy. For those investing in emerging economies or considering investment in developing markets, understanding these trends is key to managing downside risks and finding long-term opportunities amid high interest rates, shifting growth forecasts, and central bank moves.

For deeper insights, download the full Emerging Markets Equity Concentration report, which explores the growing concentration within emerging markets and its profound implications for active and passive investment strategies.

Market concentration is a global trend; it is the degree to which a small number of stocks dominate a market’s capitalization or returns. This phenomenon is also visible in the UK equity market, where key stocks have a significant impact on performance. 

The top five countries constitute 80% of the Morningstar Emerging Markets Target Market Exposure Index. Similarly, a handful of large-cap technology companies like TSMC, Tencent, Samsung Electronics, and Alibaba dominate returns in emerging markets. Together, they account for nearly 20% of the index as of December 2024. 

Market concentration is a double-edged sword for those investing in emerging economies. Large-cap dominance in index funds can boost returns during rallies but creates downside risk if those stocks underperform or macro conditions shift.

Active managers in emerging markets often struggle to beat passive strategies. Over the five years ending June 2024, just 35% outperformed, partly because TSMC and Tencent drove half of the Morningstar EM TME Index’s gains. Underweighting these names, whether by choice or due to regulatory limits, hurts performance.

The one-year outlook is stronger, with 40% of active funds ahead. Investment in developing markets benefited from avoiding weak spots like China, where many active managers trimmed exposure to outperform passive benchmarks.

China’s market concentration has shifted from “old economy” companies to “new economy” players like Tencent, Alibaba, and Meituan. Despite their dominance, regulatory challenges and economic headwinds have weighed on performance. For instance, Alibaba’s stock has more than halved over the past five years due to regulatory scrutiny and a weak consumption environment.  

Nevertheless, active managers with a nuanced understanding of China’s market dynamics have been able to exploit inefficiencies, with 60% of active funds outperforming passive peers over a rolling five-year period. 

India stands out for its relatively broad-based growth compared to other emerging markets. The country’s weight in the Morningstar Emerging Markets Index has doubled over five years, driven by structural reforms and increased foreign investment.  

The rise of mid-and small-cap companies has created opportunities for active managers, with 53% of active funds outperforming passive peers over the past decade. 

Taiwan’s equity market is highly concentrated, with TSMC alone making up 49% of the Morningstar Taiwan Target Market Exposure Index. TSMC’s growth, driven by the tech sector’s expansion and the AI boom since 2023, has been a key factor.

Over the past five years, TSMC contributed 60% of the index’s 125% cumulative return, while the top five companies—TSMC, Hon Hai, MediaTek, Quanta, and Fubon—accounted for 77% of the market’s returns. Due to TSMC’s dominance, passive investment options may be more suitable for tracking the local market, although skilled active managers with strong tech sector expertise can still add value. 

The Korean equity market is fairly concentrated, with the top five stocks making up 45% of the Morningstar Korea Index, led by Samsung Electronics at 29% as of Nov 30, 2024. This concentration means the performance of key players, especially in tech and semiconductors, significantly impacts the broader market.  

Recent growth in the top five—Samsung, SK Hynix, KB Financial, Hyundai Motor, and Naver—accounted for 85% of the Morningstar Korea Target Market Exposure Index’s 12.6% five-year return. Despite this concentration, efforts to diversify through smaller companies and foreign investment are underway. It is worth noting that Samsung Electronics has faced volatility due to slowing memory chip demand, smartphone competition, and macroeconomic challenges. 

Brazil’s market is dominated by a few mega-cap stocks like Petrobras and Vale, which account for 48% of the Morningstar Brazil Index. The country’s equity market has faced challenges, but the emergence of “new economy” stocks like fintech company Nu Holdings signals a shift toward greater diversification. 

Leverage active management in relatively less-concentrated markets. Markets like India and China offer fertile ground for active managers to outperform due to their broader investment opportunities and market inefficiencies.  

Balance active and passive strategies. Passive funds may provide efficient exposure to dominant sectors in highly concentrated markets like Taiwan and Korea, although investors should be aware of severe downside risk should the top stocks underperform, as passive funds lack the flexibility to adjust to shifting market dynamics.  

Supplementing passive investments with active strategies can help capture opportunities in under-researched areas. Investors can tilt the odds in their favor by focusing on high-quality active funds managed by experienced and skilled investment teams based on time-tested and consistently applied approaches  

Monitor macro and regulatory trends. Emerging markets are often influenced by geopolitical developments, regulatory changes, and macroeconomic factors. Staying informed about these dynamics can help investors make more confident decisions. 

Adopt a long-term perspective. Market concentration trends can create volatility in the short term, but a disciplined, long-term approach can help investors navigate these fluctuations. High-quality funds with consistent strategies are better positioned to deliver sustainable returns. 

An advisor using Morningstar Direct Advisory Suite can assess their clients’ portfolios and diversification by looking at various fund and portfolio data points, including: 

• Medalist Rating: A five-tier system that evaluates a fund’s ability to outperform its Morningstar Category index after fees. It incorporates an analysis of the fund’s management, investment process, and risk strategies, with ratings ranging from Gold to Negative based on the fund's long-term performance potential. 

• Number of Holdings: The total number of unique securities in a fund, showing its level of diversification. 

• Weighting of Top Holdings: The percentage of a fund’s assets invested in its top holdings, indicating concentration risk. 

• Sector Exposure: The percentage of a fund’s assets invested in each economic sector, assessing risk and return potential. 

• Market Cap Exposure: The percentage of a fund’s assets invested in companies of different market caps, assessing risk and return potential. 

• Correlation with Benchmarks: A measure of how closely a fund’s performance tracks its benchmark index, assessing risk and return potential. 

• Beta: A measure of a fund’s volatility relative to the market, assessing its risk and return potential. 

• Standard Deviation: A measure of a fund’s return volatility, assessing its risk and return potential. 

• Sharpe Ratio: A measure of a fund’s risk-adjusted return, useful for comparing performance across funds. 

Advisors can determine whether they are overly concentrated or diversified by analyzing these data points among other portfolio metrics. 

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